RallyCry (< 20)

An updated take on a core Buffett tenet

2

The need to understand the business you are investing in, for it to be tangible, and easy to describe to a layperson has been cited by Warren Buffett as a core principle in his investing decision making process.

One area that is overlooked when considering the "know what you invest in" principle is the time it takes to research industries outside of the investor's comfort zone. Often the subject matter is abstract and these complex concepts can not be described to others in a few sentences.

I disagree that these difficult to understand areas should be excluded from consideration. Some people have gathered specific insights by working as an equity analyst/asset manager, working in the industry, or immersing themselves in the subject matter. Other times, the complexity the average person finds in learning the business is the same trouble businesses have in duplicating a unique business model. The result can be a wide economic moat between one company and the rest of an industry. Think Intuitive Surgical and their DaVinci surgical robot. (ISRG)

Focusing on one particular area and learning cloud computing or biotechnology may take considerable months or years of research. However, if this exercise is pursued there could be sizable payoff. Market shifts and new breakthroughs may be recognized before the rest of the herd has it revealed to them in a research report or conference call. Think Salesforce's business software. (CRM)

I say invest in what you know, but also invest in learning what you don't, because the harder an industry is to understand, the greater range of investing opportunities you may discover.

This is one of the most misunderstood things Buffett has said. From reading his books and letters, what he meant was not that he doesn't understand the technology/industry (he is very smart, so he does understand them) but he does not understand how to tell which company has a long term competitive advantage, because the industry is too new, or does not fit prior criteria (low r&d, low sga costs, etc)

@ Valyooo. I'm not sure too new means that someone with extensive knowledge of an emerging industry can't pick winners and losers. After all, first movers advantage can last for years when it is supported by intellectual property. Also while Buffetts preference may be to avoid high S&G costs and high R&D, these expenses can be viewed as necessary to the structure of an industry or even a big competitive advantage. For example Pfizer spent 9 billion on R&D last year and nearly 24 billion on S&G, Intel 1.6 billion on R&D and 1.7 on S&G. There are few companies in their industry that can match these figures. I see them as value plays with sustainable competitive advantages. Researching chips and drug compounds would only help to prove or disprove this thesis.

@ikkyu2 I don't claim to have extensive knowledge of the re insurance business but on a simplified level, a company like Montpelier writes policies on property, equipment, and against catastrophic events such as terrorism for other insurance companies looking to limit the risk of "policy expenses" or claims on their own policies. They generate predictable cash flows that can be invested in investment vehicles that provide a return over invested capital such as AAA bonds.

Montpelier have about 2.8 billion in cash or other cash equivalent investments, a couple hundred million in receivables, about 800 million in reserve against catastrophic events, 300 million in debt, and about 260 million in unearned policies and the rest is common equity.

They are trading at about a 20% discount to their book value of $25 most likely becuase they have significant bond portfolio. On the bright side, based on Valyooo's Buffett criteria SG&A was only 16% of revenue and they have no R&D expense.

The big hedge fund players like Einhorm love this business because they can take the cash policies and reinvest them in more attractive companies earning a higher return. The one downside is that you can only model what you expect your policy claims will look like over time as I notice Montpelier paid out roughly 170% more in policy expense in 2010 vs. 2009 and the portfolio mix may be hit by interest rate risk, currency risk, and duration risk.

The insurance business is really simple to Buffett because he has great underwriters and they set policy rates that are almost always profitable. Buffett knows how to maximize the gain from the float so he makes a boring insurance business incredibly profitable.